Beginner's Guide to Financial Statements - Balance Sheet

The financial statements of a company consist of 3 main parts – (i) the income statement, (ii) the balance sheet and (iii) the statement of cash flows. This guide will explain the basics of the balance sheet, using the example of a fruit-seller’s business.

The Balance Sheet

The balance sheet, also known as the statement of financial position, contains the financial balances of the business – essentially showing how much capital has been built up in the business. The 3 categories of accounts are Assets, Liabilities and Equity.

Assets are things or resources that the business owns that can yield future economic benefits – for example cash, equipment and buildings. Liabilities are business obligations, i.e. obligations that are expected to result in a net outflow of economic resources – for example bank loans to be repaid and bills to be paid. Equity, also known as owners’ equity, shareholders’ equity, stockholders’ equity or other similar terms, represents the remaining interest in the assets of the business, after all the liabilities have been settled. Hence, the three categories are related by the balance sheet equation (see below) – they have to fulfill this equation or “balance”.

Assets = Liabilities + Equity

The balance sheet shows how the assets of the business are financed (or funded) using liabilities (e.g. loans) or equity (e.g. owner putting more money into the business). The balance sheet is for a specific point in time (usually date of end of year or quarter), unlike the income statement which is for the entire period. (Note the difference in the title of the two types of statements).

A simple balance sheet could look like the one below. Actual statements are more complex and have more details, but follow essentially the same structure.

Balance Sheet of Fruit-Seller Company X as at 31 December 2011

ASSETS

Cash

$5,000

Accounts Receivable

$200

Inventory

$400

Total Current Assets

$5,600

Property, Plant & Equipment (PPE)

$150

Other non-current assets

$250

Total Non-Current Assets

$400

Total Assets

$6,000

LIABILITIES AND EQUITY

Accounts Payable

$200

Short-term Debt

$250

Total Current Liabilities

$450

Long-term Debt

$300

Other Non-Current Liabilities

$100

Total Non-Current Liabilities

$400

Total Liabilities

$850

Share Capital

$5,000

Retained Earnings

$150

Total Shareholders’ Equity

$5,150

Let’s go through each item in turn, using the fruit seller as an example.

Current Assets

Current Assets are the assets that can be or are expected to be converted into cash in the short term, for example cash itself, short-term investments, accounts receivables and inventory. Cash includes physical cash at the business (e.g. in the cash registers or the safe at the fruit-seller’s store) and cash deposits at the bank.

Accounts Receivables (sometimes shortened as “A/R”) are the amount of money owed to the business by customers, i.e. where products or services delivered but payment has not been made by the customer. For example, in the case of the fruit-seller, he could have sold some fruits to a customer on 30-day credit terms – so the amount is recognized as accounts receivables during this period (until the customer makes payment).

Inventory refers to the goods that are stored in the business, for example at a warehouse or at the fruit-seller’s store for display, that are meant for sale to customers. As you can see, all of the above are readily convertible to cash in the short term (at least for normal healthy business operations).

Non-Current Assets

Non-Current Assets are the assets that will yield economic benefits or be converted into cash over a period of time. These include Property, Plant & Equipment (PPE) and long-term investments.

Property, Plant & Equipment (PPE) refers to the cost of the property (e.g. fruit-seller’s store, if he owns the store), plant (e.g. processing plant if the fruit-seller owns one) and capital equipment (e.g. a juicing machine, the cash registers used to process payments or vehicles used to transport the fruits). Land (e.g. if the fruit-seller owns the land that his store or factory is sitting on) is often also included under PPE.

Current Liabilities

Current Liabilities are liabilities that are expected to be due or paid in the short term, for example short-term loans and accounts payables. Short-term debt refers to loans (e.g. money that the fruit-seller borrowed from a bank) that are typically due in the next 1 year.

Accounts Payables (sometimes shortened as “A/P”), also known as trade payables, are the amount of money owed to suppliers that are unpaid, i.e. where goods and services have been received by the business, but payment has not been made to the supplier. In the case of the fruit-seller, he could have bought a batch of fruits from his supplier, who gives him 30 days credit terms – so the amount is recognized as accounts payables during this period (until he makes payment to the supplier). This is the reverse situation from the Accounts Receivables case mentioned earlier.

Non-Current Liabilities

Non-Current Liabilities are liabilities that are not due in the short term, for example long-term loans from banks. Long-term debt refers to loans (e.g. money that the fruit-seller borrowed from a bank) that are not due in the next 1 year.

Equity

Equity, as mentioned earlier, represents the remaining interest in the assets of the business, after all the liabilities have been settled. It includes two main categories. The first is known as shareholder capital (or other similar names) – this is the amount that equity (stock) investors, which could include public shareholders or other investors such as venture capital firms, have invested in the business over the years. For example, in the fruit-seller’s case, if he had invested $5,000 in his company in exchange for 100% of the shares in the company, the share capital is recognized as $5,000.

The second category is known as retained earnings (or other similar terms) – this is the amount of earnings that have been retained in the business over the years. It is the accumulated portion of net income which is retained by the business, rather than distributed to the owners of the business as dividends. For example, if the fruit-seller’s business made a net profit (also known as net income) of $100 last year, and the company did not pay any dividends, the $100 would be recognized in the retained earnings.

Summary

From the simple balance sheet presented above, you can see that the Fruit-seller Company X has total assets of $6,000 (which includes $5,000 of cash). These assets are financed by $850 of liabilities (with $450 of these being current liabilities) and $5,150 of equity. This is a low level of debt – it is a healthy balance sheet!

Well, this is the bare bones of the balance sheet – hope this article provides a good beginning to understanding this part of financial statements. Please feel free to comment or ask questions on anything that is not clear, so that I can improve this article. Thanks!